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Credit-Market Sentiment and the Business Cycle

Author

Listed:
  • David López-Salido
  • Jeremy C. Stein
  • Egon Zakrajšek

Abstract

Using U.S. data from 1929 to 2015, we show that elevated credit-market sentiment in year t − 2 is associated with a decline in economic activity in years t and t + 1. Underlying this result is the existence of predictable mean reversion in credit-market conditions. When credit risk is aggressively priced, spreads subsequently widen. The timing of this widening is, in turn, closely tied to the onset of a contraction in economic activity. Exploring the mechanism, we find that buoyant credit-market sentiment in year t − 2 also forecasts a change in the composition of external finance: net debt issuance falls in year t, while net equity issuance increases, consistent with the reversal in credit-market conditions leading to an inward shift in credit supply. Unlike much of the current literature on the role of financial frictions in macroeconomics, this article suggests that investor sentiment in credit markets can be an important driver of economic fluctuations.

Suggested Citation

  • David López-Salido & Jeremy C. Stein & Egon Zakrajšek, 2017. "Credit-Market Sentiment and the Business Cycle," The Quarterly Journal of Economics, Oxford University Press, vol. 132(3), pages 1373-1426.
  • Handle: RePEc:oup:qjecon:v:132:y:2017:i:3:p:1373-1426.
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    File URL: http://hdl.handle.net/10.1093/qje/qjx014
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    References listed on IDEAS

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    1. Adrian, Tobias & Boyarchenko, Nina, 2013. "Intermediary balance sheets," Staff Reports 651, Federal Reserve Bank of New York.
    2. Andrea Ajello & Thomas Laubach & J. David Lopez-Salido & Taisuke Nakata, 2016. "Financial Stability and Optimal Interest-Rate Policy," Finance and Economics Discussion Series 2016-067, Board of Governors of the Federal Reserve System (U.S.).
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    4. Gilchrist, Simon & Yankov, Vladimir & Zakrajsek, Egon, 2009. "Credit market shocks and economic fluctuations: Evidence from corporate bond and stock markets," Journal of Monetary Economics, Elsevier, vol. 56(4), pages 471-493, May.
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    9. Nicola Gennaioli & Andrei Shleifer & Robert Vishny, 2010. "Financial Innovation and Financial Fragility," NBER Chapters,in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
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    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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